II Nature of Exchange Rate Regimes
- Barry Eichengreen, Inci Ötker, A. Hamann, Esteban Jadresic, R. Johnston, Hugh Bredenkamp, and Paul Masson
- Published Date:
- August 1998
The appropriate choice of an exchange rate regime and the economic and other factors that should influence that choice are the subjects of an immense literature.1 The subject of the present paper is the reason why many developing countries are likely to find it advisable to move in the direction of regimes of greater (but not absolutely unfettered) exchange rate flexibility, and the “exit strategies” that they may choose, that is, when and how to move to a new economic policy regime with a greater degree of exchange rate flexibility. This discussion has three main parts: when and how to move to greater exchange rate flexibility when the existing policy regime is not under substantial stress; what to do and what not to do when the existing regime is already threatened; and what to do after the exit.
In addressing the issue of exit strategies, it is essential to recognize that a country’s exchange rate is but one component of its general economic policy strategy and needs to be consistent with the other components, most importantly with the conduct of monetary policy. In particular, maintenance of a pegged exchange rate regime requires commitment of monetary policy to defend the exchange rate. This typically leaves little room for monetary policy to pursue other objectives, and none at all when the exchange rate is under pressure. More generally, the policy regime for all countries, except the largest industrial countries, typically involves a clear concern, de jure or de facto, about the size and rapidity of movements in the exchange rate. For such policy concerns to be manifested in a meaningful and credible fashion, they must be supported by a willingness to adjust monetary policy and fiscal policy, as well as by the existence of adequate foreign exchange reserves and the use of nonsterilized exchange market intervention.
A country’s economic policy regime, including its exchange rate regime, constrains the way in which governments conduct their economic policies. Such constraint is not only desirable, it is essential. In order for the economic system to function efficiently and effectively, economic agents at home and abroad need to be able to form reasonably reliable expectations about how key government policies will be conducted and how they will respond to changing conditions. A policy regime without firm commitments provides no reliable basis for the formation of expectations and is, therefore, an invitation to instability. An unexpected and sudden shift away from an established policy regime to a new and untested regime, especially in an environment of economic crisis, is likely to undermine the credibility of economic policy and seriously damage economic performance. The policy regime cannot be the régime Ju jour that is adjusted without constraint to meet the conveniences and political exigencies of the moment. Rather, a good and sustainable policy regime must be like a good marriage—for better or worse, for richer or poorer, in good limes and bad. The plain fact is that no exchange rate regime and broader economic policy regime is optimal for all countries, or even for a single country, in all circumstances and conditions. A regime must be selected and adhered to on the basis of how it is expected to perform on average in the longer term. Divorce is possible, but it is costly and disruptive—and rightly so.
Selection of a country’s exchange rate regime is not a dichotomous choice between fixity and floating. Instead, it involves a spectrum of options. At the fixed end of this spectrum, a currency union with a common central bank represents the ultimate economic, institutional, and political commitment to fix exchange rates among the countries participating in the union. Legislating a currency board that rigidly links the value of domestic money to that of a foreign currency and ties the domestic monetary base firmly to the level of foreign exchange reserves generally signals a very firm commitment to a fixed exchange rate. A pegged-but-occasionally-adjustable exchange rate regime, such as the Bretton Woods system or the exchange rate mechanism (ERM) of the European Monetary System (EMS), is consistent with varying degrees of commitment to exchange rate fixity depending on the width of the bands within which exchange rates are normally allowed to fluctuate, on the determination with which the limits of these bands are defended, and on the frequency and magnitude of changes in the central parities. A crawling peg with bands of permissible fluctuation and with the possibility of adjustments in the rate of crawl or in the central peg generally suggests a lesser commitment to exchange rate fixity—although a tight crawl at a low speed with very infrequent adjustments can be “more fixed” than an adjustable peg with weakly defended wide bands and frequent changes in central parities. A managed float generally eschews de jure commitment to a particular value, band, or path for the exchange rate but does involve de facto understandings about how much the exchange rate will be allowed to move or how much such movements will be resisted in various circumstances. A managed float where the value of domestic money is tightly linked to a foreign currency (or a basket of foreign currencies) over extended periods through exchange market intervention and adjustments in monetary and other policies will look and function, de facto, very much like a fairly rigid official peg with narrow bands. A free float, where the exchange rate is regularly seen to fluctuate in substantial amounts in response to market forces without official intervention or determined adjustments of monetary and other policies to resist exchange rate movements, lies much further along the spectrum of exchange rate regimes in the direction of an absolutely unfettered float.
Under an absolutely unfettered float, no official intervention would be undertaken in the foreign exchange market, and economic policies, especially monetary policy, would be pursued with benign indifference to the exchange rate. Except perhaps some countries enduring very rapid inflation, no country, in practice, follows the policy of an absolutely unfettered float. The largest industrial countries, particularly the United States, come close. Official intervention in the foreign exchange market is modest and infrequent, and there is little indication that the Federal Reserve in setting U.S. monetary policy pays much attention to influencing the foreign exchange value of the U.S. dollar. Japan and Germany are relatively close to the United States in their apparent indifference, in most circumstances, to movements in exchange rates, except to the extent that those movements affect macroeconomic outcomes. But many of the smaller European industrial countries (and some of the larger ones) peg their exchange rates as their fundamental exchange rate and monetary policy regime. And even countries such as Canada and Switzerland, which allow their exchange rates to float freely in response to market forces, do not regard movements in exchange rates with benign policy indifference, because the latter affect the tightness or ease of monetary conditions and hence may warrant offsetting adjustment of interest rates.
For developing and transition countries, as with the smaller industrial countries, there are good reasons why the right exchange rate regime (except perhaps in cases of continuing high inflation) is not something close to an absolutely unfettered float. For countries where trade is typically a larger share of national income than for the largest industrial countries, exchange rate fluctuations of the magnitude that are seen among the major industrial country currencies would be very disturbing.2 In addition, as the foreign exchange and capital markets that influence the behavior of developing and transition country exchange rates are not nearly as broad and deep as those of the largest industrial countries, and as the basis for expectations about the conduct of economic policies that affect exchange rates is not as firmly established by long histories of reasonably stable performance, it is possible that left to themselves, exchange rates for a considerable number of developing and transition countries would fluctuate with even greater violence than exchange rates among the largest industrial countries. Quite rightly, economic policy in developing and transition economies, as in most industrial countries, will want to avoid this degree of exchange rate turbulence; and the exchange rate regime should reflect this important fact about the broader economic policy regime of which it is a part.
On the other hand, as indicated by the experiences examined in the next section, there are good reasons why many developing and transition countries are likely to find it desirable over time to move away from regimes having a considerable degree of exchange rate fixity and toward regimes of greater flexibility. Developing and transition countries are becoming more open to international capital markets: and, despite questions about the benefits of openness of the capital account that may arise in light of the financial crisis in Asia, this trend is likely to continue. Experience has repeatedly shown that an adjustable peg or a tightly managed float with occasional large adjustments is a difficult regime to sustain under circumstances of high capital mobility.3 With the knowledge that the exchange rate will be changed if pressures become too intense, strong pressures tend to build up when market perceptions shift (sometimes quite suddenly) to the view that the rate is no longer sustainable. In a situation of high capital mobility, the exchange regime needs to be either a very determined peg with consequent constraints on other economic policies, or it needs to be a managed float where the exchange rate moves regularly in response to market forces although quite possibly with some resistance from intervention and other policy adjustments.
Developing and transition countries have been becoming more open to trade, typically on an increasingly diversified basis with industrial countries and regional partners. As recent experience in Asia has shown, maintaining a tight exchange rate link to the currency of one of the major industrial countries with conducting trade and financial business with other major countries can pose significant difficulties. Growing intraregional trade linkages also pose significant problems for exchange rate pegs, especially single currency pegs, as do circumstances when regional partners and competitors are pegged to another currency, are floating, or get pushed off a common peg in a crisis. As trade continues to grow, as exchange rates among the major industrial countries continue to fluctuate, and as regional partners and competitors move away from a common currency peg, individual developing and transition countries are likely to see that their interest lies in a policy regime with greater exchange rate flexibility. There will, of course, be exceptions, particularly among countries with dominant trade and financial linkages to a single major currency area or with a need to maintain very firm discipline on monetary policy.